Very few investors can tolerate the volatility of being 100% invested in equity. Even with a long time horizon, a 20% to 30% drop in the value of your portfolio is gut-wrenching. It might cause you to sell securities just as the stock market bottoms.
In mid-June 2022, with the S&P 500 down 24% year-to-date, no one knew if the market was bottoming or if this was the start of an even more severe correction. We know that a portfolio balanced between equity, fixed income and cash, created a much less severe drop than the S&P 500 (still a painful experience). Given that a balanced portfolio is a conservative investment stance, why was the drop in portfolio value greater than what is typically experienced?
Although a rare event, even balanced portfolios occasionally do not perform as expected. The first half of 2022 was the worst six-month period of the past 50 years for a portfolio comprised of both stocks and bonds. Typically when stock markets sell off substantially, interest rates decline and the bond portion of your portfolio appreciates modestly in price. The higher bond valuations partially offset the decreased value of your equities. This did not occur in 2022, with bonds selling off by -9%.
So how frequently do stocks and bonds both decline at the same time? According to a recent Vanguard analysis (Like the Phoenix, July 2022), since 1976 this dual decline occurs in 14.8% of any given month (and much less frequently over longer periods). For the last 30 years, interest rates have been in a general decline and one could argue that this tailwind produced these very positive results. Given that we are unlikely to see a continuation of this lower interest rate trend, we should plan for a higher frequency of stocks and bonds behaving badly at the same time in the future.
I find it useful to focus on portfolio risk rather than solely on return. What setbacks in my portfolio should I plan for? How will my emotions take hold at the point of maximum expected pain? All of us have unique "uncle points" where the pain overwhelms the desire to hang in. There is substantial comfort in understanding your tolerance for volatility risk and how to minimize it through portfolio construction.
So I created for myself the Morton Investment Pain Estimator (MIPE)
In my view, investors can think of risk in two ways:
the risk that investments decline in value and never recover (terminal risk)
the risk that decline is temporary and the value will recover (volatility risk).
The Morton Investment Pain Estimator looks at volatility risk, the risk of creating sleepless nights. What decline in value might occur in various scenarios?
Example $1,000,000 portfolio
This portfolio is based on a "typical" investor (60/40 portfolio). One can fine-tune the estimator by adding in private equity, single stock positions and/or altering the portfolio weightings, etc.
Footnotes
#1, Base case is my subjective expectation of market setbacks that will occur every two to five years. Not predictable, selloffs can happen anytime.
#2, 50% Dex Bond Universe and 50% U.S. High Yield
#3, The "Average case" is based on the S&P 500 average Intra-year decline of -14% over the past 42 years. The returns of public bonds and private debt are best estimates.
#4, The last two columns are based on the actual 2022 experience.
For me, the dollars lost are more meaningful than the percentage loss in terms of addressing pain factors. In mid-June 2022 example, the loss of $172,000 focuses the issue more clearly than -17.2%
As we can see in the four examples; cash, public bonds and private debt meaningfully reduced the decline in value versus the S&P 500. True, there is a cost in holding assets that are unlikely to produce returns equal to equity over a longer time frame. Still, the non-equity portion of the portfolio can act as a cash reserve. A source of capital to fund lifestyle when stock markets fall from grace. Additionally, cash and public bonds can be sold to rebalance into the target equity allocation during a stock market decline.
Know your "uncle point" in advance. Ensure that your asset allocation matches your risk tolerance. Fully expect declines in your portfolio and take comfort in knowing that your asset allocation is appropriate.
Thoughts, agreement/disagreement? email me at tim@mortonir.com
I would be pleased to discuss this analysis in more detail and how the estimator can be modified to reflect individual asset allocation.
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Tim Morton, CFA, is a retired portfolio manager with 45 years of experience working with private clients and is the editor of mortonir.com
The Morton Investment Pain Estimator subjectively estimates potential loss in typical market declines. Declines could be more severe, as occurred in the years: 2000, 2008-2009 and early 2020. Different asset mixes will create different scenarios.
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